Inflation target is key to deflation fight, Bullard says

Fed must have credible promise to reduce money growth when threat fades

LONDON (MarketWatch) -- The risk of global deflation is a threat the Federal Reserve can counter with a credible commitment to meet an explicit target for inflation, a top Fed policy-maker said Tuesday.

The Fed's monetary policy can still have a big impact on economic growth and price stability, even though it has dropped interest rates to zero, said St. Louis Fed President James Bullard said, speaking at the Cass Business School in London.

"In the current environment, a commitment to an explicit inflation objective coupled with a systematic approach to expanding the monetary base could help avoid further disinflation and a possible deflationary trap, such as the one experienced in Japan," he commented.

"Stabilization goals can be accomplished through influence on the expected rate of inflation."

With interest rates near zero, the Fed's main lever now is growth of the money supply to keep inflation (and inflation expectations) positive. "We face some risk of further disinflation and possible deflation globally," according to Bullard. "We know that persistent monetary growth can prevent further disinflation."

"Hopefully, we can avoid a deflationary trap in 2009," Bullard said, adding that comparisons to the Great Depression are off base. The Depression was "on a whole different scale from what we are seeing right now. This is more like 1980-81."

The Fed has expanded the money supply by more than $1 trillion to combat the deflation threat. But the public is uncertain about the Fed's policy, because it doesn't know how much of the expansion is temporary ("here one day, gone the next") and how much is permanent (purchases of long-term securities expected to be held for months or years).

As a result of that uncertainty, inflationary expectations are "unusually diffuse," Bullard said. While some people fear the Fed isn't doing enough to stop deflation, others worry that the expansion of the money supply will be inflationary.

One way for the Fed to regain control over inflation expectations would be to announce an explicit target for inflation, Bullard said. "By making its long-run inflation objective explicit, the Fed could help provide a credible commitment that the growth of the monetary base will slow as deflation risks recede."

Bullard said he was very confident that the Fed could unwind the growth in money supply when it comes time to do that. "This is the essence of good monetary policy," he said.

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